Comments on: Regulate CDS as insurance

By: Benedict@Large

Benedict@Large — Tue, 07 Jul 2009 07:05:04 +0000

I very sympathetic to the CDS as insurance argument. Indeed, it’s all but impossible to tell the difference in “ordinary” situations.

Problem: In order for it to be insurance, there must be an insurable basis. Are we really sure we want this limitation on CDSs? Is it ever legitimate to short using a CDS? What about approximations to an insurable basis when a 1-to-1 mapping isn’t there? How close is close enough? An insurable basis thus seems to be overly limiting, excluding perfectly legitimate needs.

Yet you cannot mix insurable basis with anything else and still expect it to act like insurance from an experience perspective. The risk pool wouldn’t be homogeneous in terms of CDS purchaser motivations, an essential to predictable experience and necessary to prevent/manage/price adverse selection.

Wish I had an answer. A pure insurance product would certainly have a market. It just wouldn’t be a CDS.

By: Paul

Paul — Tue, 07 Jul 2009 01:51:02 +0000

I agree. In fact it should be called “CDI” instead of “CDS” because that’s what it really is.

By: Lim

Lim — Tue, 07 Jul 2009 01:11:24 +0000

Its amazing that after all these years there’s still no law regulating CDS and several other derivatives as insurance products. Speechless.

By: rc whalen

rc whalen — Mon, 06 Jul 2009 21:44:49 +0000

Nice article. To me there are several issues with CDS:

- It looks like insurance, but it is mispriced and there is no ability to pay, thus the comparison is not apt. I think the better description was used by Martin Mayer at the AIER conference, namely that CDS is gambling a la margin trading via a bucket shop in the 1920s.

- The second issue is price. The yield spread on a bond is not a good basis market for any derivative, expecially when we are talking about illiquid corporate bonds. But even more serious is the pricing of a default insurance instrument vs. short-term credit spreads. On this basis, most CDS are under-priced vs. the actual economic cost of default.

- Third and most critical is the issue of cash settlement. Because CDS have no connection to the real world “basis” market and players can settle in cash, without any requirement to deliver the underlying basis, risk is infinite. Thus CDS is arguably the great engine of systemic risk in the world today.

Best,

Chris

By: mickeyc

mickeyc — Mon, 06 Jul 2009 19:59:19 +0000

This is a good article.

The only obvious flaw is confusing volume with liquidity. If you have capital of $100 and borrow $1,000 it is easy to make the mistake that you are providing liquidity of $1,100. As has been proved ad nauseum in the history of finance the only real part of this transaction is the $100. There is always a mechanism whereby the $1,000 gets called on by the lender and this always happens.

Goldman Sachs demand for collateral from AIG is a recent example. AIG could not meet the call as the money did not exist – it was a fiction agreed to between GS and AIG.